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When callable bonds are redeemed below carrying value

12/11/2021 Client: muhammad11 Deadline: 2 Day

Financial Accounting: Tools for Business Decision Making

Eighth Edition

Kimmel ● Weygandt ● Kieso

Chapter 10

Reporting and Analyzing Liabilities

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Financial Accounting: Tools for Business Decision Making

Chapter Outline:

Learning Objectives

Explain how to account for current liabilities.

Describe the major characteristics of bonds.

Explain how to account for bond transactions.

Discuss how liabilities are reported and analyzed.

L O 1: Explain How to Account for Current Liabilities

What is a Current Liability?

A debt that a company expects to pay

from existing current assets or through the creation of other current liabilities, and

within one year or the operating cycle, whichever is longer.

Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest.

What Is a Current Liability? (1 of 2)

Review Question

To be classified as a current liability, a debt must be expected to be paid within:

a. 1 year.

b. the operating cycle.

c. 2 years.

d. (a) or (b), whichever is longer.

What Is a Current Liability? (2 of 2)

Review Question

To be classified as a current liability, a debt must be expected to be paid within:

a. 1 year.

b. the operating cycle.

c. 2 years.

d. (a) or (b), whichever is longer.

Notes Payable (1 of 4)

Written promissory note.

Usually require the borrower to pay interest.

Frequently issued to meet short-term financing needs.

Issued for varying periods of time.

Those due for payment within one year of the balance sheet date are usually classified as current liabilities.

Notes Payable (2 of 4)

Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value.

Sept. 1

Cash

100,000

Notes Payable

100,000

Notes Payable (3 of 4)

Illustration: If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest.

Dec. 31

Interest Expense

4,000 *

Interest Payable

4,000

Notes Payable (4 of 4)

Illustration: At maturity (January 1), Cole Williams Co. must pay the face value of the note plus interest. It records payment as follows.

Jan. 1

Notes Payable

100,000

Interest Payable

4,000

Cash

104,000

Sales Taxes Payable (1 of 3)

Sales taxes are expressed as a stated percentage of the sales price.

Selling company

collects tax from the customer.

remits the collections to the state’s department of revenue.

Sales Taxes Payable (2 of 3)

Illustration: The March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is:

Mar. 25

Cash

10,600

Sales Revenue

10,000

Sales Taxes Payable

600

Sales Taxes Payable (3 of 3)

Sometimes companies do not ring up sales taxes separately on the cash register.

Illustration: Cooley Grocery rings up total receipts of $10,600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, (sales tax rate of 6%), the journal entry is:

Mar. 25

Cash

10,600

Sales Revenue

10,000 *

Sales Taxes Payable

600

* $10,600 ÷ 1.06 = $10,000

Unearned Revenues (1 of 2)

Revenues that are received before goods are delivered or services are performed.

Company increases (debits) Cash and increases (credits) a current liability account, Unearned Revenue.

When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.

Type of Business

Airline

Magazine publisher

Hotel

Unearned Revenues (2 of 2)

Illustration: Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sales of season tickets is:

Aug. 6

Cash

500,000

Unearned Ticket Revenue

500,000

As each game is completed, Superior records the earning of revenue.

Sept. 7

Unearned Ticket Revenue

100,000

Ticket Revenue

100,000

Current Maturities of long-term Debt

Portion of long-term debt that comes due in the current year.

No adjusting entry required.

Illustration: Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2016. This note specifies that each January 1, starting January 1, 2017, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2016,

What amount should be reported as a current liability?

$5,000

What amount should be reported as a long-term liability?

$20,000

Do It! 1: Current Liabilities

You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.

If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?

The cash register total including sales taxes is $23,320, and the sales tax rate is 6%. What is the sales taxes payable?

$23,320 ÷ 1.06 = $22,000; $23,320 − $22,000 = $1,320

If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?

Payroll and Payroll Taxes Payable (1 of 4)

The term “payroll” pertains to both:

Salaries - managerial, administrative, and sales personnel (monthly or yearly rate).

Wages - store clerks, factory employees, and manual laborers (rate per hour).

Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay.

Payroll and Payroll Taxes Payable (2 of 4)

Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows:

Mar. 7

Salaries and Wages Expense

100,000

F I C A Taxes Payable

7,650

Federal Income Taxes Payable

21,864

State Income Taxes Payable

2,922

Salaries and Wages Payable

67,564

Record the payment of this payroll on March 7.

Mar. 7

Salaries and Wages Payable

67,564

Cash

67,564

Payroll and Payroll Taxes Payable (3 of 4)

Payroll tax expense results from three taxes that governmental agencies levy on employers.

These taxes are:

F I C A tax

Federal unemployment tax

State unemployment tax

Payroll and Payroll Taxes Payable (4 of 4)

Illustration: Based on Cargo Corp.’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows.

Payroll Tax Expense 13,850 Blank
F I C A Taxes Payable Blank 7,650
Federal Unemployment Taxes Payable Blank 800
State Unemployment Taxes Payable Blank 5,400
21

Payroll Taxes (1 of 2)

Review Question

Employer payroll taxes do not include:

a. federal unemployment taxes.

b. state unemployment taxes.

c. federal income taxes.

d. F I C A taxes.

Payroll Taxes (2 of 2)

Review Question

Employer payroll taxes do not include:

a. federal unemployment taxes.

b. state unemployment taxes.

c. federal income taxes.

d. F I C A taxes.

Anatomy of a Fraud

Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.

Total take: $150,000

The Missing Controls

Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees or direct-deposited into approved employee bank accounts.

Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts.

Do It! 1b: Wages and Payroll Taxes (1 of 2)

During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (F I C A), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company’s payroll tax expense.

Sep. 30

Salaries and Wages Expense

60,000

FICA Taxes Payable

3,500

Federal Income Taxes Payable

6,500

State Income Taxes Payable

2,000

Salaries and Wages Payable

48,000

Do It! 1b: Wages and Payroll Taxes (2 of 2)

Sep. 30

Payroll Tax Expense

3,740

FICA Taxes Payable

3,500

Federal Unemployment Taxes Payable

State Unemployment Taxes Payable

150

L O 2: Describe the Major Characteristics of Bonds

Bonds are a form of interest-bearing notes payable issued by corporations, universities, and governmental agencies.

Sold in small denominations (usually $1,000 or multiples of $1,000).

When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.

Types of Bonds (1 of 2)

Secured and Unsecured Bonds

Secured bonds have specific assets of the issuer pledged as collateral for the bonds.

Unsecured bonds are issued against the general credit of the borrower.

Types of Bonds (2 of 2)

Convertible and Callable Bonds

Convertible bonds can be converted into common stock at the bondholder’s option.

Callable bonds can be redeemed (bought back), by the issuing company, at a stated dollar amount prior to maturity.

Issuing Procedures (1 of 2)

Bond certificate

Issued to the investor.

Provides name of the company issuing bonds, face value, maturity date, and contractual (stated) interest rate.

Face value - principal due at the maturity.

Maturity date - date final payment is due.

Contractual interest rate – rate to determine cash interest paid, contractual rate is stated as an annual rate.

Alternative Terminology

The contractual rate is often referred to as the stated rate.

Issuing Procedures (2 of 2)

Determining the Market Price of Bonds

The current market price (present value) of a bond is a function of three factors:

the dollar amounts to be received,

the length of time until the amounts are received, and

the market rate of interest.

The process of finding the present value is referred to as discounting the future amounts.

Determining the Market Value

Illustration: Assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in five years, with interest payable annually at year-end.

Present value of $100,000 received in 5 years $ 64,993
Present value of $9,000 received annually for 5 years 35,007
Market price of bonds $ 100,000 double underline
33

Do It! 2: Bond Terminology

Indicate whether each of the following statements is true or false.

Secured bonds have specific assets of the issuer pledged as collateral.

True

Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity.

True

The contractual interest rate is the rate investors demand for loaning funds.

False

The face value is the amount of principal the issuing company must pay at the maturity date.

True

The market price of a bond is equal to its maturity value.

False

L O 3: Explain How to Account for Bond Transactions

A corporation records bond transactions when it

issues (sells) or redeems (buys back) bonds and

when bondholders convert bonds into common stock.

Bonds may be issued at

face value,

below face value (discount), or

above face value (premium).

Bond prices are quoted as a percentage of face value.

Issuing Bonds (1 of 2)

Review Question

The market interest rate:

a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.

b. is listed in the bond indenture.

c. is the rate investors demand for loaning funds.

d. More than one of the above is true.

Issuing Bonds (2 of 2)

Review Question

The market interest rate:

a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.

b. is listed in the bond indenture.

c. is the rate investors demand for loaning funds.

d. More than one of the above is true.

Issuing Bonds at Face Value (1 of 2)

Illustration: Devor Corporation issues 100, five-year, 10%, $1,000 bonds dated January 1, 2017, at 100 (100% of face value). The entry to record the sale is:

Jan. 1

Cash

100,000

Bonds Payable

100,000

Prepare the entry Devor would make to accrue interest on December 31.

Dec. 31

Interest Expense

10,000

Interest Payable

10,000

Issuing Bonds at Face Value (2 of 2)

Prepare the entry Devor would make to pay the interest on Jan. 1, 2018.

Jan. 1

Interest Payable

10,000

Cash

10,000

Discount or Premium on Bonds (1 of 3)

Issue at Par, Discount, or Premium?

▼ Helpful Hint

Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.

Discount or Premium on Bonds (2 of 3)

Review Question

Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

Discount or Premium on Bonds (3 of 3)

Review Question

Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:

a. the contractual interest rate exceeds the market interest rate.

b. the market interest rate exceeds the contractual interest rate.

c. the contractual interest rate and the market interest rate are the same.

d. no relationship exists between the two rates.

Issuing Bonds at a Discount (1 of 2)

Illustration: Assume that on January 1, 2017, Candlestick Inc. sells $100,000, five-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is:

Jan. 1

Cash

98,000

Discount on Bonds Payable

2,000

Bonds Payable

100,000

Issuing Bonds at a Discount (2 of 2)

Statement Presentation

Sale of bonds below face value causes the total cost of borrowing to be more than the bond interest paid.

The issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity.

Total Cost of Borrowing (1 of 2)

Bonds Issued at a Discount

Annual interest payments Blank
($100,000 × 10% = $10,000; $10,000 × 5) $50,000
Add: Bond discount ($100,000 − $98,000) 2,000
Total cost of borrowing $52,000 double underline
Bonds Issued at a Discount

Principal at maturity $100,000
Annual interest payments ($10,000 × 5) 50,000
Cash to be paid to bondholders 150,000
Less: Cash received from bondholders 98,000
Total cost of borrowing $52,000 double underline
45

Issuing Bonds at a Discount

Amortization of bond discount:

Allocated to expense in each period.

Increases the amount of interest expense reported each period.

Amount of interest expense reported each period will exceed the contractual amount paid.

As the discount is amortized, its balance declines.

The carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount.

Issuing Bonds at a Premium (1 of 2)

Illustration: Assume that the Candlestick Inc. bonds previously described sell at 102 rather than at 98. The entry to record the sale is:

Jan. 1

Cash

102,000

Bonds Payable

100,000

Premium on Bonds Payable

2,000

Issuing Bonds at a Premium (2 of 2)

Statement Presentation

Sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid.

The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing.

Total Cost of Borrowing (2 of 2)

Bonds Issued at a Premium

Annual interest payments Blank
($100,000 × 10% = $10,000; $10,000 × 5) $50,000
Less: Bond premium ($102,000 − $100,000) 2,000
Total cost of borrowing $48,000 double underline
Bonds Issued at a Premium

Principal at maturity $100,000
Annual interest payments ($10,000 × 5) 50,000
Cash to be paid to bondholders 150,000
Less: Cash received from bondholders 102,000
Total cost of borrowing $48,000 double underline
49

Issuing Bonds at a Premium

Amortization of bond premium:

Allocated to expense in each period.

Decreases the amount of interest expense reported each period.

Amount of interest expense reported each period will be less than the contractual amount paid.

As the premium is amortized, its balance declines.

The carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount.

Do It! 3a: Bond Issuance

Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.

(a)

Cash

189,000

Discount on Bonds Payable

11,000

Bonds Payable

200,000

(b)

Long-term liabilities

Bonds payable

$200,000

Less: Discount on bonds payable

$189,000

Redeeming Bonds at Maturity

Candlestick records the redemption of its bonds at maturity as follows:

Bonds Payable

100,000

Cash

100,000

Redeeming Bonds before Maturity (1 of 2)

When a company retires bonds before maturity, it is necessary to:

eliminate the carrying value of the bonds at the redemption date;

record the cash paid; and

recognize the gain or loss on redemption.

The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.

Redeeming Bonds before Maturity (2 of 2)

Illustration: Assume at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, retires the bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2021) as:

Jan. 1

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